Iceland Offshore Krona Investors Need Incentives, IMF Says

Iceland needs to make it more attractive for offshore kronur investors to use the island’s program to unwind krona controls as progress in freeing capital flows remains slow, the International Monetary Fund said.

“To accelerate progress it’s necessary to strengthen the incentives for holders of liquid offshore krona to participate in the liberalization strategy,” the IMF said in a statement.

Iceland’s central bank is seeking to phase out the controls by 2015 through dual currency auctions of kronur and euros. The program is designed to take pressure off the krona even as investors sell their holdings by offering financial benefits and the option of reinvesting in the island.

The IMF estimates that the stock of assets frozen by the controls is 23 percent of the economy, a number it says “could rise significantly” as the island’s failed banks wind up their estates. Including such assets, the figure may grow to about $8 billion, compared with Iceland’s gross domestic product last year of $13.5 billion, according to Arion Bank hf.

“The number one priority should be to remove the terminal date in the legislation on the capital controls,” Daria V. Zakharova, the IMF’s mission chief to Iceland, said in an interview. “In our view it may have made the central bank’s strategy to liberalize the capital controls more difficult.”

Krona Sitting

The deadline creates incentives for people sit on their kronur and “hope to exit on more favorable terms down the road,” she said. “The whole idea of the strategy was to make it conditions based -- there shouldn’t be a terminal time line for it. So we think by removing this we can actually speed up the reduction in the offshore krona overhang.”

The Washington-based lender hasn’t discussed the specifics of how an exit tax on offshore krona holders would be applied, said Zakharova, although “it should be sufficiently strong to incentivize people to exit sooner and through more favorable channels such as the eurobond swap and the auctions, rather than resorting to use the exit tax.”

Iceland’s government has said it is unlikely to return to a free-floating krona and has signaled it will probably switch to the euro after joining the European Union, for which it started accession talks in 2010.

Outlook Good

The north Atlantic island’s economic outlook is “good” and Iceland is this year likely to “broadly” repeat an economic growth rate of 2.6 percent achieved in 2011, the IMF said. An orderly unwinding of the capital controls is key to Iceland’s continued recovery, the fund said.

A working group consisting of members from the IMF, the European Commission, the European Central Bank and Icelandic officials is due to deliver an interim report on options for removing the capital controls by year-end, the finance ministry said on Sept. 25.

“It’s hard to say” whether Iceland can abolish the capital controls within five years, said Zakharova. “They could be lifted much sooner, again if there are good incentives in place to exit sooner.”